American Conference Institute’s 2nd Advanced Forum on CAPTIVE INSURANCE April 24-25, 2014 - The Carlton Hotel Madison Avenue, New York, NY Use of Protected Cell Company and Series LLC Structures – The Basics Thomas M. Jones McDermott Will & Emery LLP [email protected] (312) 984 7536 Cell Company Structure POOLED LAYER - CORE CAPITAL Cell A Cell B Cell C Cell D 2 Offshore Cell Captive World (>20) . Segregated Accounts Company (SAC) Bermuda SAC Act 2000 . Separate Accounts Company Bermuda Private Acts of Parliament – since 1991 . Protected Cell Company (PCC) Gibraltar Protected Cell Companies Act of 2001 Guernsey Protected Cell Company Ordinance 1997 . Segregated Portfolio Company (SPC) Cayman Islands Companies Law 2000 (Revised 2006) British Virgin Islands Business Companies Act (Revised 2005) 3 Onshore Cell Captive World (>14) . Sponsored Cell Captives - Vermont Special Insurer Act of 1999 . Sponsored (formerly Leased Capital) Cell Captives - Hawaii Hawaii Revised Statutes 2000 . Protected Cell Captive Insurers - DC Captive Insurance Company Act of 2004 . Protected Cell Companies - SC Protected Cell Insurance Company Act of 2000 4 Varied Uses of Cell Captives What types of captive programs are in cells? . Pure/single parent risks (conglomerates) - Separation – By product line – By geographic area . Group and/or association shared risks . Transformers, funds & financial guaranty companies . Hospital/clinics/independent physicians . Agency risk participation . SPVs – securitization; XXX life insurance . Composite insurers – separating life & non-life lines 5 “General Account” . Also called “core capital” . Corresponds with general assets and liabilities in standard balance sheet of an ordinary company . Open issue depending on PCC domicile – Can core contract with a cell? Can one cell contract with another? 6 “Segregated Account” . Generically called a “cell” . Identifiable assets segregated or distinguished from other assets of company for the purposes of creditor protection whether in a solvent situation or insolvency proceeding . “Open” Cell – Assets of core available (at least to a specified amount) to satisfy creditor of cell . “Closed” Cell - Assets of core not available to satisfy creditor of cell 7 Will Cells’ Separateness Be Respected? . Concept of separating assets and liabilities in self- contained cells seems valid, but has not yet been judicially tested . Two key factors to enhance success: – Governing law/venue must be the domicile – Cell assets (i.e., custody of investments) should be located in the domicile . Reason: contrary to insolvency principle of horizontal “equitable distribution” (pari passu) of assets to creditors; cell structure is a vertical distribution only within the cell 8 Experience in Bermuda . SAC mutual fund litigation in Bermuda Supreme Court – Tensor Endowment Limited vs. New Stream Capital Fund Limited – Segregation a peripheral issue, but efficacy upheld (9/23/10) . Litigation involving wind up (liquidation) of SAC cell – Matter of CAI Master Allocation Fund Ltd. (2011) – Judge described the cell wall as a “statutory iron curtain” – But left open its breach if used as an instrument of fraud 9 AMBAC Insolvency in Wisconsin . Pending mortgage guaranty insurance cell insolvency litigation in Wisconsin – See Plan of Rehabilitation for the Segregated Account of Ambac Assurance Corporation filed by the Wisconsin Office of the Commissioner of Insurance on 10/8/10 at http://ambacpolicyholders.com; plan approved by Dane County Circuit Court on 1/26/11 – Cell formed on 3/24/10 to sequester certain assets and liabilities under long standing Wisconsin law – Issue was whether the IRS & other Ambac creditors could pierce the cell wall – The Segregated Account reached a compromise with the IRS & Ambac creditors without breaching the cell walls – approved by the federal bankruptcy court on 5/1/13 10 Key U.S. Tax Issues – Insurance or Self Funding? . Premium deductibility by policyholder? . Loss reserve deductibility by company? . Controlled foreign corporation status? . How is shareholder taxed under Subpart F? . Possible passive foreign investment company (PFIC) treatment? . Applicability of federal excise tax? 11 Tax Authorities Supporting a Single Company . Life insurance company “separate asset accounts” - see, e.g., Rev. Rul. 74-4 and TAM 9807001 . Taxation of “regulated investment companies” (mutual funds) – see, e.g., Union Trusteed Funds, 8 TC 1130 (1947) and Rev. Rul. 56-246 . PFIC statutory rule re classes of stock – see IRC §1298(b)(4) . Moline Properties separate corporate existence doctrine 12 Tax Authorities Supporting a Single Company . Life insurance company “separate asset accounts” - see, e.g., Rev. Rul. 74-4 and TAM 9807001 . Taxation of “regulated investment companies” (mutual funds) – see, e.g., Union Trusteed Funds, 8 TC 1130 (1947) and Rev. Rul. 56-246 . PFIC statutory rule re classes of stock – see IRC §1298(b)(4) . Moline Properties separate corporate existence doctrine 13 Authorities Supporting “Multi-Corporations” . Legislative history to 1997 IRC amendments states that use of “separate accounts” will be respected to prevent risk sharing . Federal Bank Holding Company Act of 1977 regulations concluding that each cell of a rent-a-Captive type structure should be considered a separate corporation . Possible impact of future budget proposals regarding public company subsidiary “tracking stock” 14 Factors Influencing Multiple “Mini-Corporations” Outcome . Is core capital at risk? Must it be replaced via assessing other cells? . Does company-wide or cell-by-cell governance prevail? (Cell statutes specify only 1 governing board) . Is primary/stop-loss/excess coverage and collateral for “front” on a company-wide or cell-by-cell basis? . Are each cell’s assets invested on a separate or commingled basis? . Are cell owners risking significant capital? . Separate or composite GAAP financial accounting treatment? 15 2008 IRS Cell Captive Guidance 16 Rev. Rul. 2008-8 General Account Y X Cell X Cell Y Preferred Shares Insurance Insurance Policy Policy Covering 1 12 Brother/Sister Group . No Insured except for X . Adequate capital . No guarantee of Cell X obligations . No subsidiary < 5% nor >15% . Adequate capital . No loans . No loans . No guarantees by Y or Y1 → Y12 of Cell Y obligations . Annual policy . No other insurance contracts . Homogeneous risk . Annual policy 17 Rev. Rul 2008-8 – Look to existing rules; apply on cellular basis • Risk shifting • Risk distribution – Arrangement between X and Cell X akin to a parent and wholly-owned subsidiary. Rev. Ruls. 2002-89 & 2005-40 – Arrangement between Y and Cell Y characterized as brother/sister insurance. Rev. Rul. 2002-90 – Should have been a 3rd situation in which Cell Z owned by Z wrote > 50% unrelated risk with holding of insurance under Rev. Rul. 2002-89 18 IRS Notice 2008-9 Proposed Guidance . Cell of a PCC would be treated as an insurance company separate from any other entity if: – Assets and liabilities segregated – Based on facts and circumstances cell would be classified as an insurance company . Tax Effect – Elections at cell level – Cell must apply for FEIN if subject to U.S. tax – Cell activities not taken into account in characterizing PCC’s “general account” (core) – Cell (or parent, if consolidated) responsible for filing returns and paying tax – PCC does not include income items with respect to cell 19 IRS Notice 2008-19 Comment Period – To implement this guidance, taxpayer comment requested by 5/5/08 regarding: • Transitional rules • Reporting, if any, necessary to ensure PCC has needed information • Special rules regarding foreign entities (including CFCs) • Treatment of PCCs and cells under consolidated return rules • How to handle segregated arrangements not involving insurance – Note no inference on tax status of PCC core or its non-insurance cells – Effective date would be for tax years beginning more than 12 months after this guidance is finalized 20 IRS Proposed Regulations Issued 9/13/10 – Not Yet Finalized 21 Prop. Treas. Regs – General Rules . Regs explicitly state they do not address the proper tax characterization or filing requirements of the core . If a cell is classified as a separate corporate entity, then it will be treated like any other corporation, including the ability to make stand alone tax elections . Regs will not override general tax law principles – for example, if a cell has no business purpose other than tax avoidance, it still will be disregarded as a “sham” . Regs indicate that ownership of a cell will be determined to be whomever “bears the economic burdens and benefits of ownership” of the cell (shares = contracts?) 22 Prop. Treas. Regs – Domestic Cell Captives . Every cell will be treated as a separate taxpayer, except for segregated asset accounts of a life insurance company . The fact that state law does not consider the cell to be a separate entity is not important . Regs cite Vermont and South Carolina cell captive provisions, but this same rule should apply to cell captives formed in all other domestic domiciles with similar laws, including the District of Columbia 23 Prop. Treas. Regs – Domestic Cell Captives . The cell's separate entity status will be respected even if the cell fails to comply with statutory record keeping requirements negating the limitation of liability . The cell's separate entity status will be respected even if, through an arrangement such as guarantees, the debts and liabilities of a cell are enforceable against assets of another cell 24 Prop. Treas. Regs